Is the banking sector rapidly disintegrating into some real-life version of The Mad Hatter’s tea party from Alice in Wonderland?
Forget the volumes of technical debate on the current moves to save the banks. Let’s just step back and use common sense. Consider just a few recent events.
Suspension of Mark to Market Accounting
Using this method, mortgaged backed securities were valued just like any other asset for which there is an active market - as of the latest sale prices for similar assets on the open market, just like you would determine a fair price for a house, car, business, or toaster. Prices of various kinds of debt have been reasonably discounted severely because there is now increased risk of default, just like used car prices drop with age and mileage because of the increased risk of loss from repair costs.
With the suspension of “M2M”, the banks and government are attempting to inflate the value of banking assets based solely on current cash flow. By this logic, because GM bonds are current on interest payments, they should be valued at 100% of par rather than the 10% or less that reflects the risk of future default.
It’s like saying that critically ill patients on life support are as healthy as anyone else as long as they continue to breath.
The Fed Accepting Lower Quality Collateral
Instead of just top-rated sovereign debt (admittedly no longer risk free), the Fed now accepts in certain cases investment grade corporate bonds and commercial paper, residential and even commercial real estate loans.
- Residential Real Estate loans: Increasing joblessness (even at a declining rate of growth) means more mortgage defaults. Also, remember that employment is a lagging indicator, and thus will not improve until later in still unseen recovery.
- Commercial real estate loans: As I’ve noted earlier, the bankruptcy of GGP, the largest mall REIT, casts genuine doubt about the stability of retail property valuations for the foreseeable future.
- I haven’t even begun to discuss the manipulations needed to achieve the illusion of earnings improvements. Too technical for now.
What Investors Can Do
Because I believe critique without a practical remedy is of limited value for my readers, I leave you all with one simple strategy to protect your portfolios for the day when the façade falls away.
Short the Financial Sector
In short, by one means or another, short the financials.
One simple idea: The Ultrashort Financials (SKF). As the below chart shows, these are at multiyear lows that are not justified the above noted facts in the banking sector. Given that these are at multi-year lows, you’ll know quickly if this support won’t hold, so you can set sell stops within 10% below these levels to keep your risk low. Given the recent highs, the possible risk / reward makes this a worthwhile trade.
Obviously there are other means, like shorting individual banks.
Given the manipulations already seen, it is not far-fetched to assume other “extra-market” manipulations means might be used to artificially prop up the banks or other assets. Government imposition of “bank holidays,” currency controls, extraordinary “emergency” legislation have all been used in the past and could be used again. We may be right in our analysis, but still not profit.
Based on the evidence we have, the optimism for the financials is overdone, and the SKFs are a good way to play that, at least for a short term hedge. Of course, if the financials swoon again, so will the rest of the market, so other ultrashorts like SDS, SRS, and TWM are ideas to consider as well.
My readers know I’m more of a buy and hold investor for income, not a short term trader. However, a good investor must be flexible and be willing to look at the facts, draw conclusions, and take appropriate action, even if it goes against one’s nature.
I have positions in most or all of the above mentioned securities.